Litany of Hope

The world seems to be in recovery mode. Global stock markets – and until recently, bond markets, too – have been enjoying fantastic rallies. House prices largely remain on the rise, and consumers continue to delve into their pocketbooks. Sure, there’s a bit of a problem with unemployment, and the dollar doesn’t look so hot, either. Nor do the twin deficits. But hey…the Fed is steering us into clearer waters, right? It’s just the price we must pay to spark a recovery, yes?

Or is it? Let’s take a look at the Fed’s reasoning.

There are three main pillars of the U.S. economy: business spending (capital investment), housing and consumer spending. The Fed’s current hope is that if the latter two pillars, housing and consumer spending, can simply hold their own long enough, normal (even if below-trend) growth will eventually allow the economy to work through excess capacity. The way would then be clear for the first pillar, capital spending, to become once again a source of major economic growth.

The problem is that housing and consumer spending only thrive in two environments. Either low mortgage and borrowing rates are needed to stimulate housing and consumer spending, or the economy must be aggressively growing well above trend, adding jobs and increasing personal income so that even in the face of rising rates, these markets will maintain steady growth.

Art Cashin: A Massive Series of Rate Cuts

The latter case certainly does not describe today’s economic environment. And so, the Fed has responded in the only way it could: it has engendered a massive and prolonged series of rate cuts, accompanied by significant growth in the money supply. While some maintain it has created two new bubbles in both housing and bonds, the Fed has managed to maintain the strength of the housing market, and with lowering credit costs, rising borrowing and ‘cash- out’ from mortgages, the U.S. consumer market has remained fairly resilient.

Thus, up until last week, the Fed policy of lowering short- term rates (plus threatening to work on long-term rates if necessary), had been enough to keep interest rates falling and the economy moving forward…albeit sluggishly. But perhaps the traditional lever of lowering short-term rates, plus rhetoric, may no longer be enough.

Two weeks ago, for instance, the Fed continued its rate-cutting policy by slashing 25 basis points from the Fed Funds rate. But the release that accompanied the announcement was almost identical to earlier, meaningless statements. Looking at the most recent Fed release, Art Cashin (UBS head floor trader and of CNBC Fame) wrote:

“Let’s talk about the directive and its language to see what we can learn of the Fed’s informed view on the current state of the economy and monetary policy. In paragraph two they begin:

“‘The Committee continues to believe that an accommodative stance of monetary policy, coupled with still robust underlying growth in productivity, is providing important ongoing support to economic activity. Recent signs point to a firming in spending, markedly improved financial conditions, and labor and product markets that are stabilizing.’

“That sounded vaguely familiar, so we started looking back at directives over the last three years of rate cutting. We found the theme was rather repetitive. Here’s what they said, or rather wrote, in early December of 2002.

“‘The Committee continues to believe that this accommodative stance of monetary policy, coupled with still robust underlying growth in productivity, is providing important ongoing support to economic activity. The limited number of incoming economic indicators since the November meeting, taken together, are not inconsistent with the economy working its way through its current soft spot.’

“We did not make this up. You are encouraged to go to the Federal Reserve website and read each of the directives over the last three years.

“Net/net the latest directive is part of a litany of hope. Thirteen rate cuts and the hope that things will improve as they always have (according to the guidebook).”

Art Cashin: Daddy’s Home

Art and I discussed the Fed’s articulacy – or lack thereof – over dinner not long ago. Art made a very interesting observation. What the markets really want to hear from the Fed, he said, is that everything will be all right – “Daddy’s Home.”

Given the violent rise in bond yields since that time, that was not what the bond markets heard. Given the significant rise in unemployment only a week after the Fed meeting in which they proclaimed “labor markets…are stabilizing,” the concern is that Daddy may be clueless.

In Art’s analogy, “Daddy’s Home” is supposed to represent some sense of stability. Investors simply want to have some reasonable certainty of the future. They have been willing to give the Fed the benefit of the doubt, as long as Fed governor speeches constantly and consistently proclaim their intent to work on keeping long-term rates down.

But the recent Fed statement, with its same-song, 30th- verse litany of hope, gave no sign of that. Some took the Fed’s reticence as a hint that it sees a strong recovery and will be raising rates soon. Others thought that this would be the last cut, therefore bonds had nowhere to go but down. Confusion, the enemy of bonds, was evident.

Art Cashin: A Steepening Yield Curve

The bond markets threw up. 10-year bond rates, which are the key to mortgage rates, rose from 3.07% to 3.65% in a week. Longer rates have risen similarly. The yield curve has “steepened,” which is precisely the opposite of the results the Fed wants.

It is not hard to imagine mortgage rates rising 0.50% fairly rapidly. Given the speed of the recent interest rate move, could another 0.50% be in the future? Is a 1% rise in mortgage rates enough to hurt the housing market? I am not suggesting the housing market will implode, but given the fragility of the economy and a rising unemployment rate, it could slow the growth enough to send us into recession.

The Fed is playing a dangerous game. Bond markets in Japan and Europe are also in wholesale retreat. The carnage in Japanese bond markets makes our markets look calm by comparison. On July 4, the Financial Times told us that the S&P has threatened to downgrade Japanese bonds again in the light of recent bond market turbulence.

If the recent bond market trend stabilizes, my concerns will evaporate. Long-term rates are still low enough to keep housing and consumer spending from falling out of bed. But my concern is that a trend is developing that will arrest the stability of the housing and mortgage markets, pushing us over the edge into a recession and deflation.

Regards,

John Mauldin
for the Daily Reckoning
July 8, 2003

P.S. None of this has to happen. The cure is simple. The Fed simply needs to become transparent. They need to tell investors, from institutions down to Mom and Pop, exactly what to expect, instead of keeping everyone in a guessing game. The market is saying that speeches are no longer enough. Actions speak louder than words. We need to know in an official release whether the Fed intends to keep long rates down, and what it will do to accomplish this.

This is not to say that the Fed necessarily knows what it will do. But the principles upon which it makes its decisions and the process should be readily transparent, so as to allow investors to make more informed choices.

—————-

Summertime and the livin’ is easy… Fish are jumpin’ and the cotton is high.

Eric Fry is at the beach…and Addison is on his way to the hospital, where his wife is expecting a baby.

Here in Paris, the sun is shining…the weather is warm. Sidewalk restaurants and cafes are full…and even our local oracle – a wiry little alcoholic who lives on the rue de la Verrerie in the summer months – is back. We saw him this morning on our way to work, stretched out on the pavement like a plague victim. But it was yesterday’s triple-digit gain in the Dow that put a bounce in our step and a song in our hearts. It was like old times…1999 to be exact. It made us feel a little younger…and even a little wiser. For whenever the sun shines longest and hottest, we know what happens next: the days get shorter.

Everything had a retro look yesterday. Gold fell below $350. And the dollar even rose against the euro; it was up to $1.13 by the close of business yesterday.

And even though the nation has just gone through its longest period without growth in the number of jobs since WWII, USA Today thinks it sees improvement coming. “Several signs hint at recovery in the job market,” says its headline.

The good times rolled all around the world. The French are enjoying a mini-boom in the bourse. German stocks look good, too. And in Japan – where stocks recently achieved a 20-year low – the Nikkei seems to be heading up. Yesterday, it reached an 11-month high.

Is it time to get back into Japanese stocks, asked a Daily Reckoning reader, as if we would know.

‘Maybe,’ is our answer.

“I believe we are approaching a major low in the Japanese stock market,” was Marc Faber’s guess in May. Now it looks as though the low may have already come and gone.

“Sometime this year,” Faber continued, “investors will have to be long Japanese equities and short Japanese bonds. It is only a matter of time before investors will pull out money from the ridiculously priced bond market (yielding less than 0.6%) and buy equities.”

Yesterday, Japanese bonds dropped. So did U.S. bonds. And the bonds of practically every other nation.

After seeming to promise a 50 bps. rate cut, Alan Greenspan disappointed bond investors with a piddling cut of half that amount. Then, on Thursday, Wim Duisenberg of the European Central Bank announced no cut at all.

Failing to cut rates would not normally be good news for the cause of inflation, but such is the dizzy world we live in that bond investors sell off bonds for fear that the central banks may not drive rates lower…and that a Japan- style deflation lies not right around the corner…and that it may be summertime in the world’s financial markets longer than they had thought.

All the world’s central bankers, of course, are on the side of inflation. They do not merely tolerate it, but insist upon it. Currently, both bond and stock investors are betting that they will get what they want.

We are not so sure.

We spent much of the weekend repairing bicycles. Checking tires for leaks, we noticed that if we put too much air in the tube, it would bulge out in unpredictable places. For amusement, we kept adding air. The bubbles multiplied; the tube grew hideously deformed…until, finally, one of the bubbles popped and the whole thing deflated.

“Hey, Dad, what are you doing to my tire?” Edward wanted to know, bringing us back to the point of the exercise…which was not to study the effects of too much air, but to give the kid a working bicycle.

And so, we rushed into town and got a new tube, put it in the tire…and off Edward went with his friends, Adrien and Otto.

Predictably, we began to think about the way Mr. Alan ‘Bubble’ Greenspan has continued to pump more and more credit into the entire world economy, despite grotesque deformations. Pretending not to notice, he allowed the biggest stock market bubble in history to develop. Then, when it popped, he quickly applied a patch and began pumping again. This time the bond market bubbled out. Just as investors had come to believe that the Maestro wouldn’t allow anything bad to happen to stocks in the late ’90s, by the early ’00s they were sure that he wouldn’t, nay couldn’t, permit a collapse in bond prices.

Last week, a hissing noise started coming from the bond bubble. Investors with sharp ears should listen carefully. Because the refinancing bubble may have also sprung a leak. Long-term mortgage rates have gone up since Greenspan’s latest 25 bps cut. If homeowners can no longer ‘take out equity’ from their homes…what will they do? Will not the whole bubble economy finally blow up in our faces?

How can you profit from the bond bubble’s collapse? From our colleague, Dan Denning, comes this advice:

“Here are two investment ideas, if you think the bond bubble has been pricked but still has plenty of leaking to do.

“First, check out the Goldman Sachs iShare Corporate Bond Fund (LQD). It’s the simplest way to be ‘short’ the entire corporate bond market in one investment and it trades just like a stock (meaning you can buy options on it too.) The fund mimics the performance of the Goldman Sachs InvestTop Index. 32% of its holdings are bonds in the consumer sector, 19% in technology and telecom, and 26% in financials. In other words, the bulk of the fund’s holdings are in sectors that have directly benefited from low interest rates and have a lot to lose if and when rates rise.

“Or, if you believe, as I do, that interest rates on long- term U.S. Treasuries will rise (unless the Fed actively intervenes), you can buy puts on Lehman’s 7-10 year Treasury bond index (IEF).”

*** As we passed the skinny body sprawled on the street, we gave him a nudge with our foot to see if he was still alive.

“Hey…Oracle…wake up…”

“Heh? Oh…it’s you…”

The man rolled his head on the cobblestone, from side to side, trying to sober up. He opened his eyes wider…

“Can you spare a franc or two…” he asked, forgetting that francs haven’t been used in France for nearly 2 years…

“Yes, but first a question…is this the end of the secular bear market that began in 2000? Or just a bear market rally?”

“I told you the last time you asked. If you want this kind of advice, it will cost you more than a couple francs…”

“Okay…how about this… a two euro coin…”

“Okay, that’s more like it…ah yes…the secular bear market…forget about it. Forget the stock market. The real story is in the dollar. So what if the U.S. stock market goes up another 10% or 20%…? If the dollar goes down 50% as it did in the last cyclical dollar bear market, you’ll lose a lot more than you gain. But I have news for you. This is no cyclical dollar bear market. It’s secular…no, systemic…maybe even epochal. The last time the dollar went down, the U.S. had no current account deficit. None. It was about even with the rest of the world. Now, it has a deficit of more than 5% of GDP.

“And that was also just about the time Alan Greenspan took his post at the Fed, and thus before he began to increase the world’s supply of dollar-based credit more than all the previous fed chairmen combined – by more than $2 trillion. You would have to be crazy to want to buy U.S. bonds under these conditions…hah…you’d be better off lending ME money! Here’s my advice. Sell stocks. Sell bonds. Buy gold whenever it goes below $350. Then, wait. Relax. By the time this is over, you’ll be able to buy a lot more bonds and stocks with your gold. And if not, you can buy a bottle and join me right here.

“There, that’s worth 2 euros…”

Maybe more.

*** More about the bond market – among other things – from our friend John Mauldin, below…